Assessing Contagion Risks in Emerging Economies

Highlights

Emerging economies have become a focal point for investors, as a handful of countries have experienced significant currency pressures over the past year. Some observers are questioning whether this development could be the precursor of a new bout of financial contagion.

My own assessment is that a replay of the contagion that occurred in Latin America and Asia in the 1990s or during the euro-zone crisis is unlikely. The reason: Currency pressures have been confined to countries with large current account deficits and/or relatively high inflation. Moreover, the external imbalances, indebtedness, and inflation rates in most emerging economies are well below levels associated with previous crises.

The risk of contagion cannot be ruled out entirely, however, as it is difficult to know how much leverage there is in the respective corporate sectors and banking systems. Also, a significant slowing of China's economy or problems in China's financial system would likely affect emerging economies adversely.

In these circumstances, we believe investors need to pick and choose among emerging economies carefully: Compared to previous cycles when they moved up and down in tandem, we believe there will be greater differentiation of performance going forth.

Increased Pressures on Emerging Market Currencies

Over the past year there has been an ongoing build up in currency pressures for several emerging market countries. These pressures were linked initially to the Federal Reserve's surprise announcement in May-June that it was contemplating phasing down its quantitative easing (QE) program of bond purchases. The announcement was accompanied by a surge in U.S. bond yields, and it spawned a wave of capital flight from countries that included Brazil, India, Indonesia, South Africa, and Turkey – the so-called "fragile five."

A second bout of capital flight occurred at the beginning of this year, which was associated with added pressures on the Turkish lira, a devaluation of the Argentine peso and political problems in Thailand, Ukraine, and Venezuela. Policymakers in several countries including Turkey, Brazil, and South Africa responded by boosting short-term interest rates. When these moves had only a temporary effect in calming markets, the situation culminated in a sell-off in world equity markets and a rally in intermediate and long-dated U.S. Treasuries.

Emerging Market Contagion: Common Themes

Amid these developments some observers have questioned whether global markets are now vulnerable to a bout of contagion such as occurred during the "tequila crisis" of 1994-95, the 1997-98 Asian financial crisis, and the euro-zone crisis. These bouts had several elements in common: Namely, the countries that precipitated the crises were defending a fixed exchange rate, ran large current account imbalances, had relatively high levels of external debt, and their financial systems were vulnerable to capital outflows:

1994-95 Mexican peso crisis. During the first half of the 1990s, many emerging economies that maintained pegs to the dollar borrowed heavily from abroad to take advantage of low U.S. interest rates. The combination of easy monetary policies and massive capital inflows contributed to increased current account deficits that left countries vulnerable when U.S. monetary policy was tightened in 1994. The first victim was Mexico, which kept the peso in a narrow band versus the dollar while it ran a large current account deficit equivalent to 7% of GDP. As U.S. interest rates surged in 1994, capital left the country and foreign exchange reserves were depleted, and the peso subsequently fell by 45% against the dollar in a short period. This development, in turn, placed pressure on other currencies in the region, including the Brazilian real and the Argentine peso. Ultimately, the United States and the IMF had to provide financial assistance to Mexico, while the Federal Reserve eased monetary policy to alleviate the situation.

1997-98 Asian financial crisis. The triggering event for the Asian financial crisis was a devaluation of the Thai bhat of more than 50% that spilled over to other ASEAN countries. The countries that were most adversely impacted had large current account deficits and high levels of external indebtedness that ranged between 100%-180% of GDP. These countries responded by raising short-term interest rates significantly to counter capital outflows. However, instead of calming markets, these actions contributed to a run on domestic banks that further undermined investor confidence. The crisis eventually spread to northern parts of Asia and other geographic regions and culminated with the collapse of Long Term Capital Management in September of 1998, which prompted the Fed to ease monetary policy.

The euro-zone crisis. The precipitating event for the euro-zone crisis was a revelation that the Greek government's fiscal situation was much worse than had been reported by official sources: The budget deficit for 2009 turned out to be 12.7% of GDP, or roughly twice the magnitude originally reported, and debt outstanding reached 120% of GDP. With European financial institutions holding large amounts of Greek debt, investors were worried that a Greek default could precipitate a run on European banks. There was also worry that if Greece was forced out of the euro-zone, problems could spill over to other countries such as Portugal, Ireland, Italy, and Spain that were recipients of sizable capital inflows. The market turbulence continued to spread until mid 2012, when Mario Draghi, the head of the ECB, announced that it was prepared to do whatever was needed to defend the euro, including purchasing sovereign debt of the trouble countries.

Mitigating Factors Today

Compared to these episodes, we believe the risks today are not as great for a variety of reasons:

The "fragile five" countries whose currencies are under pressure are not attempting to defend a fixed exchange rate. Their currencies appreciated considerably when the Fed implemented several rounds of quantitative easing in 2009-2012, and their currencies have subsequently depreciated by 12%-24% over the past year. One benefit is that their international competitive positions are improving, which should foster current account adjustment.

Most other emerging economies are running surpluses or current account imbalances today that are well below those in crisis periods. Also, total foreign currency debt held by emerging economies is well below that during the crisis periods. According to BCA Research, total external debt of emerging economies has declined from 136% of GDP in 1995 to 75% at present, while gross external interest payments have fallen from 7.5% of exports to 2.5%. (see U.S. Bond Strategy, February 4, 2014). At the same time, FX reserves have soared.

Several of the countries whose currencies are under pressure – notably India, South Africa, and Turkey – have responded by raising interest rates to stabilize conditions. While some have criticized these moves on grounds they increase the risk of recession, the policy actions were needed because interest rates were low or negative after adjusting for inflation.

Why Contagion Cannot Be Ruled Out Entirely

While the above considerations suggest the problems in emerging economies are mainly concentrated in a select group of countries, we cannot rule out the possibility of contagion for several reasons.

One reason is that we do not know the extent of leverage and interconnectedness in the corporate sectors and within their banking systems. One example: Turkey is in the spotlight partly because about 70% of its $340 billion in foreign currency debt is concentrated in the private sector. With the lira having depreciated by 60% since 2010, the ability of Turkish debtors to meet their obligations has been impaired. According to BCA Research Inc., the main creditors are banks from the U.K., France, Greece and Spain, with combined exposure of $123 billion (see Global Investment Strategy, January 31, 2014). The BCA report observes: " …even if some Turkish banks default on their foreign debt, the size of the default would be limited and the impact on the rest of the world would not be 'systemic.' Nevertheless, so long as there is no clarity, global financial markets will remain jittery."

More generally, there was significant build-up in private sector debt in some emerging economies when credit was readily available. In many instances, the borrowing did not flow into productive investments. Consequently, returns on capital in some countries – especially the resource rich economies – are low, and soft commodity prices have added to pressures on share prices. This is an area where information is less readily available.

Another consideration is the fate of emerging economies will continue to be influenced by developments in China, where there are concerns about a possible slowdown and potential problems in the shadow banking system. According to J.P. Morgan, the impact of Chinese slowing on global growth is estimated to dampen growth in emerging markets by 0.73 percentage points over four quarters (see Global Data Watch, January 31, 2014):

"This could be a testament to the importance of Chinese demand to the commodity exporters in Latin America as well as the importance of the US as a final demand engine for EM Asia. Notably, the importance of China in the EM is on par with that of the US and Euro area, despite it being roughly half their size."

Thus, while we continue to believe the Chinese economy will avoid a "hard landing," we also acknowledge either an economic slowdown or problems in its financial system would weigh heavily on emerging economies.

Investment Implications: Differentiating Among Countries

One of the key differences today from the past two decades is that the performance among emerging economies is more disparate. By and large, the countries that are now in the spotlight are ones that are the most dependent on foreign capital inflows such as the "fragile five," or others where there is heightened political uncertainty such as Argentina and Venezuela. At the same time, other emerging economies with sound economic fundamentals and political stability are faring better. Moreover, the so-called "PIIGS" – Portugal, Ireland, Italy, Greece and Spain, which were hammered during 2010-2012, are now among the best performing markets.

This development suggests that investors are weighing the opportunities and risks within the emerging economies very carefully, which is a healthy development and the way we are viewing the current situation. Looking forward, we believe emerging economies will continue to be a source of market volatility until there is greater clarity on their corporate indebtedness and on China's economy. However, as long as investors are able to differentiate among them and not view them as a bloc, the risk of financial contagion is lessened.

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